Syllabus – 3
Main Questions the Capital Markets Class Will Answer
This class will focus on answering two main questions
The first question is the “thinking” part of our class and is:
How do financial markets work?
The next question is the “doing” part of our class, which builds on the first question, and is:
What is the best (optimal) investment portfolio for you to hold?
There will be lot of sub-questions to these two main questions that we will answer as we go through the class
Syllabus – 4
Perspective of the Capital Markets Class
This class will answer the previous questions from two different perspectives
The main approach we will use is quantitative analysis, which uses mathematical and statistical techniques to determine portfolio strategies
In Module 2 we will use these techniques to study what is called the passive approach to investing and indexing
The other approach we will examine is the traditional active management approach to stock picking
In Module 3 we will do this via fundamental analysis (discounted cash flow analysis) and the multiples approach, both of which you might remember from Fin I/ACF
Modules 4 through 6 will use quantitative techniques for both passive, as well as active, investment strategies such as arbitrage trading
Please be aware that the quantitative approach uses a lot of regression analysis, which is the backbone of quantitative investing as it is practiced on Wall Street today
Syllabus – 5
Besides the lectures, we will have a series of cases and portfolio trading simulations to understand:
1. Different financial securities you can invest in
2. Different portfolio strategies (investment philosophies) you can employ
We will predominately study bonds, stocks, mutual funds and exchange-traded funds (ETFs)
We will briefly discuss investing in commodities and real estate
Note that this class is not just about making money via your investments, but equally important, about how to minimize potential investment loses
Class Overview
Syllabus – 6
Outline of Class
Module 1: Beginnings
Module 2: How to Trade Securities
Module 3: Advanced Portfolio Theory
Module 4: Stock Picking
Module 5: Factor Models
Module 6: How do Financial Markets Work
Module 7: Asset Pricing Models and Active Investing
Module 7: Endings
Syllabus – 7
Are you a CFA?
If you are already a CFA, I strongly recommend that you do NOT take this class
This class covers material that is required knowledge for the CFA exams
Therefore, if you have a CFA you will find the material covered in this class to be very rudimentary and a review of material you already know
CFA’s that have taken the class in the past have all strongly suggested I discourage CFA holders from taking this class
Syllabus – 8
Grading StructureTask
Percent of Grade withoutMidterm
Percent of Grade withMidterm
Case Assignments 18% 18%
Case Participation GradeYour individual score for a case assignment will be increased
or decreased based on your in-class participation
Group Peer Evaluations Peer evaluations reduce an individual’s overall case score
Portfolio Simulations 4% 4%
Online Quizzes 4% 4%
Midterm 0% 25%
Final 65% 40%
Class Participation 9% 9%
Syllabus – 10
Realized returns vs. expected returns
Risk
Details on some financial instruments: Different types of bonds, different types of stocks
Interest rate risk (duration)
Credit risk
Module 1: Introduction to Financial Markets
Syllabus – 11
Module 1 Case
Exchange-Traded Funds at Vanguard
Vanguard Group management, led by CEO John Brennan, was considering whether to launch exchange-traded funds (ETFs) in early 2000. ETFs, first created in the early 1990s, combined aspects of traditional mutual funds and closed-end funds. Because ETFs were exclusively index-tracking products, Vanguard, the largest index mutual fund company, had some potential expertise in managing ETFs. However, entering this market would present also unique challenges for Vanguard. Vanguard had a philosophy espousing low-turnover investing, while ETFs enabled short-term trading. The company would also need to develop a distribution network for ETFs. Finally, since Vanguard's mutual fund investors owned the company, management considered whether existing shareholders would benefit from an ETF product launch
Learning objective:
To educate students about how exchange-traded funds (ETFs) work, their differences from other types of mutual funds, and the strategic issues for ETFs going forward
Syllabus – 12
Trading Securities
Primer on trading: Market orders and limit orders
Buy-side market participants and their holdings: Households, mutual funds, dealers, brokers, hedge funds and high frequency traders
Reading:
“The Wolf Hunters of Wall Street”
Syllabus – 13
Module 2 Portfolio Simulation
Baseline Stock and Bond Portfolio
In the first portfolio simulation students will create a portfolio of one stock exchange traded fund and one bond mutual fund
This will be a baseline portfolio that will be used as a performance benchmark for the other portfolios created during the quarter
Syllabus – 14
Quick review of Fin 1 or Accelerated Corporate Finance (ACF) material on portfolio theory
Portfolio theory for when you are considering investing in more than two assets
Minimum-variance frontier
Capital allocation line and the tangent portfolio
Selecting the optimal portfolio with a utility function
Rebalancing a portfolio
Module 3: Advanced Modern Portfolio Theory
Syllabus – 15
Module 3 Case 1
Choosing Mutual Funds for Retirement Accounts (A)
Focuses on an individual's decision to participate in her firm's retirement plan and how to invest her contributions. The (A) case focuses on which mutual funds the participant should invest in. Plan participants have a choice of 24 mutual funds with different investment strategies. Includes data from Morningstar on the composition and performance of the different funds and historical data. Uses Northwestern’s new 403(b) plan as its example
Learning objective:
To expose students to the concepts of Sharpe ratios and mutual fund/exchange-traded fund fees and their role in selecting investments
Subjects covered:
Investments; Mutual funds; Pension plans; Personal finance; Retirement savings; Mutual fund and exchange-trade fund fees; Sharpe ratios
Syllabus – 16
Module 3 Case 2
Creating Your Own Portfolio
This case is for students who do not currently have an investment portfolio. The case instructs students in how to create a hypothetical portfolio that they will analyze during the quarter
Learning objective:
To expose students to the principals security selection
Subjects covered:
Asset allocation; Asset management; Portfolio management;
Syllabus – 17
Module 3 Case 3
Optimizing Your Portfolio
This case has you take your current investment holdings and then optimize the portfolio to increase its return while minimizing its risk. For those students who do not have an investment portfolio, the will use the portfolio they create in the “Creating Your Own Portfolio”
Learning objective:
To expose students to the principals of portfolio theory
Subjects covered:
Asset allocation; Asset management; Portfolio management;
Case reading:
Vanguard’s Diversification Strategy
Syllabus – 18
Module 3 Portfolio Simulations
Your Investment Portfolio and Your Optimal Investment Portfolio
In two different trading simulations students will use their investment portfolios (including the portfolios created in the “Create Your Own Portfolio” case)
The first simulation has students buy their current portfolio
The second simulation has students buy their optimized portfolio from the “Optimizing Your Portfolio” case
Across the term students will compare the performance of these two simulations to each other and to the baseline stock and bond portfolio created in the Module 1 simulation
Syllabus – 19
The process of picking a stock
Finding a stock to pick: stock screening
Overview and strategic position of picked firm
Define investment theses and forecast firm’s financials
Conduct DCF and multiples calculations
Value firm
Selecting portfolio weights: the Kelly Criterion
Reading:
“The Risk and Fall of Performance Investing”
“Concentrated Investing”
Module 4: Stock Picking
Syllabus – 20
Module 4 Case
Stock Picking
In this case groups screen for a mispriced stock they want to invest. After they have picked a stock they will value the stock via multiples and discount cash flow (DCF) analysis to determine its target price
Learning objective:
To expose students to the basic principle of stock picking
Subjects covered:
Stock picking; Asset allocation; Asset management
Syllabus – 21
Module 4 Simulation
Your Stock Pick
In this portfolio simulation students will trade the stock they picked in the “Stock Picking” case or another stock of their choice
Syllabus – 22
Module 5: Factor Models
Multifactor models
Fama-French three-factor model
Carhart four-factor model
Macroeconomic factor models
Three factor model for bonds
Investing with factor models: Smart beta ETFs
What are they and the value added (if any) of investing in them
Readings:
Characteristics, Covariances, and Average Returns
Dissecting Anomalies with the Five-Factor Model
Explorations in Factors Explaining Money Market Returns
Luck versus Skill in the Cross-Section of Mutual Fund Returns
Syllabus – 23
Module 5 Case 1
AQR’s Moment Funds (A)
AQR is a hedge fund based in Greenwich, Connecticut, that is considering offering a wholly new line of product to retail investors, namely the ability to invest in the price phenomenon known as momentum. There is a large body of empirical evidence supporting momentum across many different asset classes and countries. However, up until this point momentum was a strategy employed nearly exclusively by hedge funds, and thus not an investment strategy available to most individual investors. This case highlights the difficulties in implementing this "mutual funditizing" of a hedge fund product, along with the challenges that the open-end and regulatory features that a mutual fund pose to many successful strategies implemented in other contexts
Case readings:
Aspects of Investor Psychology: Beliefs, Preferences, and Biases Investment Advisors Should Know About
Fact, Fiction and Momentum Trading
Syllabus – 24
Module 5 Case 2
Smart Beta Exchange-Traded Funds and Factor Investing
iShares by Blackrock is considering launching an innovative investment management product in the rapidly evolving ETF space, a multifactor ETF. iShares is the world market leader in the overall ETF market, as well as the newer smart beta ETF market. To understand the motivation for this product they reviewed recent academic literature on what are relevant factors that drive investment returns and factor investing. iShares needed to determine if this new multifactor ETF had value added over the ETFs they already sold
Learning objective:
To examine the launching of an innovative factor-based smart beta ETF in the investment management industry
Subjects covered:
Competitive strategy; Corporate strategy; Financial instruments; Investment management; Investments; Smart beta exchange-traded funds
Syllabus – 25
Module 5 Case 3
Your Portfolio’s Performance
Students will examine the performance of their personal portfolio. The performance analysis will be conducted with a factor model. Students are to decompose the return and risk of their portfolio relative to individual factors and active management
Learning objective:
To study the details of portfolio performance measurement
Subjects covered:
Portfolio performance; Active management; Asset allocation; Stock picking ability
Syllabus – 26
Module 6: Arbitrage and Active Trading
Law of one price
Law of no arbitrage
Arbitrage trading with stocks
Stock picking with arbitrage
Arbitrage trading with bonds
Syllabus – 27
Module 6 Simulation
Pairs Trading
In this simulation exercise students enter into a pairs trade using the stock they selected in the previous “Your Stock Pick” simulation and another stock picked for this simulation
Students need to find a stock to pairs trade with their original stock that they picked. The new company needs to be a comparable firm with their original stock pick. To form the pairs trade, the two stocks need to be mispriced relative to each other, one too expensive and the other too cheap. They can use any metric(s) they wish to determine that the stocks are (1) similar and (2) mispriced relative to each other
Syllabus – 28
Module 7: Asset Pricing Models and Active Trading
What is an asset pricing equation?
The CAPM’s asset pricing equation
The arbitrage pricing theory
Arbitrage trading with an asset pricing model
Equilibrium asset allocation
Syllabus – 29
Module 8: Endings
Miscellaneous material Putting the pieces together: How financial markets work The passive investment process How to diversify your portfolio How to select specific investments How to determine your portfolio weights Trading your portfolio How to measure and monitor your portfolio’s performance Rebalancing
The active investment process Screening Picking Valuing
Beware of behavioral biases Current academic and Wall Street research A few expectations for the future of personal investing